Why Netflix's CEO Is Warning Investors About the Stock

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Corporate earnings announcements failed to impress investors today and stocks could get no traction, as the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average both ended the day within 0.05% of Friday's prices.

One growth darling did impress investors today, however: Online film and TV subscription company Netflix reported results for the third quarter after today's market close, matching Wall Street's expectations for revenue of $1.1 billion and beating the $0.49 earnings-per-share forecast by three cents.

Symbolically, Netflix has now surpassed HBO in terms of domestic subscribers, with 31 million. The market liked what it saw, sending the shares up more than 10% in after-hours trading, but is this justified when the ordinary session closing price already represents 159 times estimated earnings per share over the next 12 months?

The question for Netflix investors isn't whether the company offers an attractive service, or whether it commands customer loyalty or whether the business is performing (the answer to all of those is a resounding "yes.") Instead, the question investors (or prospective investors) ought to be asking themselves is to what degree those qualities are reflected in today's stock price.

CEO Reed Hastings and CFO David Wells offer some perspective on this question in today's third-quarter earnings letter, in a section titled "Stock Volatility":

In calendar year 2003 we were the highest performing stock on Nasdaq. We had solid results compounded by momentum-investor-fueled euphoria. Some of the euphoria today feels like 2003.

Despite the huge swings in our stock price since our 2002 IPO ($8 to $3 to $39 to $8 to $300 to $55 to $330), we've continued to grow our membership every year fairly steadily. We do our best to ignore the volatility in our stock. The progress we've made over the last 10 years is stunning. We want to make the next 10 years even more remarkable.

Translation: Netlix shares are always been highly volatile, even though one of the key drivers of the business -- membership -- has increased at a relatively even pace over time. This year, the massive run-up in Netflix's stock may well have outpaced the progress in its underlying fundamentals as a result of investor euphoria.

Netflix isn't the highest-performing stock in the Nasdaq Composite Index so far this year; instead, it ranks 45th among 2,427 (within the top 2%), with a price return of 260%, according to data from S&P Capital IQ. However, among large-cap components of the index, those with a market capitalization in excess of $10 billion, its 260% price return is enough to rank it second behind only Tesla Motors' stock (which, boasting a 441% year-to-date return, looks very frothy indeed).

Crucially, for long-term investors, Reed Hastings has a Warren Buffett-like disregard for short-term stock-price movements. Instead, he focuses his attention and energy where he can make a difference: on delighting his customers and building a durable franchise. However, investors should heed his warning that the stock price may have become partially disconnected from the business fundamentals, and they ought to be prepared to ride out significant volatility if they want to be long-term owners.

In 2004, the year after it had been the highest-performing stock on the Nasdaq, Netflix was the worst-performing stock of any current Nasdaq component, handing shareholders a stunning 55% quotational loss.

The enormous market Netflix could ownAmericans reportedly spend nearly 34 hours a week watching television! With TV viewing taking up almost as much time as the average work week, the potential for profits in the space is enormous. The Motley Fool's top experts have created a new free report titled "Will Netflix Own the Future of Television?" The report not only outlines where the future of television is heading but also offers top ideas for how to profit. To get your free report, just click here!